I know I’ve posted about the misuse of the concept of irrationality before, but a recent Robert Frank NY Times column is a ridiculous exercise in irrationality storytelling. Frank writes:

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits, even those that are uncertain, or that occur in the distant future. In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift.

Given the conditions under which human nervous systems evolved, these aspects of our behavior are unsurprising. Because immediate threats to survival were pervasive, those who didn’t seize short-term advantage often didn’t survive.

Such nervous systems provide an erratic guidance system for the invisible hand. Consider, for example, the difference between actual investor responses to the housing bubble and those predicted by standard economic models.

When house prices are rising steadily, mortgage loans are safe, but relatively low-yielding, investments. During the recent bubble, unregulated wealth managers created mortgage-backed securities that enabled investors to magnify their returns through financial leverage — that is, by enabling them to invest money borrowed from others.

I’m not sure that seizing short-term advantage is actually how we evolved, but it’s not quite as content-free as evolutionary psychology, so I’ll let it slide. Onto the storytelling:

Wealth managers faced a tough choice of their own, since they knew that many customers would desert them if they failed to offer the higher-paying, but riskier, investments. Managers also knew that if markets turned against them, penalties would be limited by the fact that almost everyone had been following the same strategy. The resulting collapse was all but inevitable.

Ah yes, pity the poor wealth manager who simply wants to be noble, but… The Invisible Hand! How mighty it is!

Does Frank know anyone in that business? Many who get into it have “The Number”–the amount of money they need to stash away so they can retire (oddly enough, sex workers have a similar concept…). Granted, they might be unrealistic about what it takes to reach the Number, and others might revise the Number upwards, but if your goal is to sock away a ton of loot as fast as you can so you can get the hell out, then riskier investments are rational, particularly if you don’t have to eat the downside.

Sure, riskier investments might screw the rest of us, but they shouldn’t be viewed as a byproduct of cognitive screwups, but as a strategy that actually makes sense (for the investment manager, anyway).

If the story I’m telling is partially (or mostly) accurate, then stopping this harmful behavior is relatively straightforward: alter the income tax code such that managers are forced to think long term. Higher marginal rates would require people to stick around for the long haul–and long-term economic failure would harm their futures–forcing them to think long term and make more responsible, less risky investments.

Comments

The same competition will drive the same offerings, whether the money manager is experiencing a 30% or 45% top marginal rate. Higher tax rates in European nations didn’t prevent similar offerings there. The problem was and is more systemic than misbehaving money managers, but that risk was not adequately surfaced, and there was the pretense that it could be eliminated through insurance in the form of credit swaps, whose counterparties weren’t actually able to cover the aggregate risk they assumed in that unregulated market. The real lesson is that when financial derivatives start to act in the market as insurance, the counterparties need to be regulated as insurers.

What you’re describing is a problem of agency. Agency theory is rather heavily researched in economics, but I don’t know that there are many solutions in the toolkit.

The only one I’m aware of is to change the compensation structure to match the desired results. In other words, defer enough compensation that losses do accrue to the managers. For instance, instead of cash bonuses offer slow-vesting options with a short exercise window.

The problem comes in part thanks to poor owner governance: pocket boards and so forth.

The concept under discussion is not irrationality, but perverse incentives. People were following strategies that were rational for them but not for their employers or the economy as a whole.

Just one example among many: the negatively amortizing option ARM. Qualifying people for mortgages that they obviously cannot pay except by an artificial initial reduction of monthly payments to the point where they don’t even cover the interest is self-evidently stupid if you’re on the hook when the inevitable default occurs. But if you get a fat up-front fee for originating the loan, which is then sold off to some other sucker^H^H^H^H^H^Hinvestor who takes all the risks of default, then putting your customers into this type of product makes sense, at least for you personally.

To paraphrase one of my econ profs, “All behavior is rational. The interesting question is how people are perceiving the costs and the benefits. A toddler can make the perfectly rational decision to touch a hot stove because it’s glowing and it looks interesting.”